The business of assessing hedge funds and their managers has received a double boost â but those doing the assessing can expect to be tested by conflicts of interest.

The first fillip came from the UK hedge fund working group chaired by former Bank of England deputy governor Sir Andrew Large. This published its best practice recommendations, setting out standards for risk management, portfolio valuation and disclosure, to enhance confidence in the industry.

The guidelines were primarily aimed at the UK but could be adopted worldwide. Paul Marshall, chairman of UK hedge fund manager Marshall Wace and a member of the working group, said he hoped investors would push their managers to adopt the standards.

The second boost arrived last week when the Financial Services Authority published an overview of its findings from visiting a range of UK hedge fund managers. The regulator said it was “disappointed” by the complacency some hedge fund managers exhibited towards market abuse and other regulations, although it found that others had installed appropriate controls.

Several companies hope to take advantage of the gap between hedge fund managers’ aspirations, as expressed in the working group report, and the reality as described by the FSA. They include credit rating agencies Moody’s, Standard & Poor’s and Fitch; independent investment consultants Schmidt Research Partners and Allenbridge, and certification firm Amber Partners.

Allenbridge has been providing ratings since 2000. Jacob Schmidt, the founder of the service, left amicably last year to set up Schmidt Research Partners. This gave its first rating, for fund of hedge funds manager Gottex, in September, and last week rated four funds of hedge funds from UK firm Signet Capital.

The newcomer is Moody’s, which began rating US hedge funds last year and last month wrote its first report for European hedge fund Brevan Howard.

The need to impress institutional investors has left managers more willing to consider a rating.
But potential conflicts of interest arise because the decision to hire and retain a rating firm rests with fund managers, who stand to gain from a good rating. The fact the rating fee is paid from the fund, and therefore by investors, is incidental – as with the audit of a company, the shareholders pay the bill but the directors control appointments.

The conflicts issue was reignited by rating agencies awarding the highest ratings to structured investment vehicles, only to see them collapse this summer.

Those aiming to asses hedge funds should expect conflicts to arise when dealing with managers, where the link between livelihood and reputation is much tighter than the relationship between a public company’s profitability and its credit rating, according to Schmidt. He said: “I am blunt. I tell managers if they need to do a lot of work before I will give them a rating that says they are worth investing in. If you don’t live up to best practice we won’t give you a rating.”

Schmidt said his firm tries to minimise conflict by insisting on three-year contracts and charging a fee that does not vary with assets under management but depends on location and complexity and in practice varies little between managers.

He said he was not afraid to downgrade a manager and to take the rating away if the quality falls below single-A, the minimum for recommending an investment. He said he downgraded managers while he was at Allenbridge.

Varvara Papavasiliou, head of fixed-income analysis at UK investment firm Forsyth Partners, which rates traditional funds and runs a fund of hedge funds business, said she had removed ratings from traditional firms over the past eight years. She said: “We have not had a situation where a manager has disagreed with a decision once we have explained why we took it.”

Forsyth last week reduced to AA the rating of a traditional fixed- income fund run by Thames River Capital, a UK traditional and hedge fund manager. Varvara said Thames River had been a client of Forsyth’s for more than five years, and said: “We would not rate products where we feel doors are not open to us at the fund manager.”

The approach to assessment varies widely between firms. Standard & Poor’s and Moody’s focus on back-office operations, Schmidt Research Partners rates a fund based on the three criteria of a manager and its back office, the terms and conditions for investing and the fund’s portfolio, investment performance and risk.

Amber Partners does not offer ratings but provides a certificate asserting that the manager has appropriate controls to reduce risks such as fraud or mis-statement of value. Reiko Nahum, chief executive of Amber, who founded the firm two years ago, said no situations had arisen where it wanted to consider withdrawing a certificate but it reserved the right to do so.

Nahum said: “Clients must have a commitment to best practice. Most of them have engaged us because they want to know their strengths and weaknesses and what the rest of the industry is doing, so they can improve.”